Why Is Higher Inflation Pushing Our Bond Yields Down?

Rising inflation would normally be expected to push bond yields and mortgage rates higher.

Inflation erodes the purchasing power of money over time, so if investors believe there will be more of it, they will demand a greater return on their money in order to ensure that their expected future profits are protected.

At least, that’s how it is supposed to work in economics class.

When Statistics Canada released its latest Consumer Price Index (CPI) last Wednesday, a funny thing happened. Despite the fact that the latest report, for June, showed average prices rising by 2.40% on a year-over-year basis, Government of Canada (GoC) bond yields fell on the news.

That’s strange because this was the second month in a row that the rise in our CPI has come in higher than the 2.00% inflation target that is used by the Bank of Canada (BoC), and our inflation rate now stands at its highest level in more than two years. While there are many economic indicators that influence the direction of bond yields at any given time, very few are as important as the rate of inflation in the CPI. So why didn’t bond yields surge higher on the news?

For starters, most of the momentum that has pushed our average inflation rate higher has been confined to a small subset of CPI inputs.  David Rosenberg recently pointed out that higher utilities, meat, and gasoline prices have added a full percentage point to our headline inflation rate, despite the fact that they comprise only about 10% of the CPI on a weighted basis. In fact, Rosenberg calculates that the rest of the CPI is rising at a much more subdued 1.4% year-over-year pace.

Better still for those hoping that the recent run-up in our inflation rates won’t push mortgage rates higher, BoC Governor Poloz has repeatedly said that he believes the current surge in inflation will prove transitory (as a reminder to my newer readers, he’s the guy who decides when to raise our variable mortgage rates).

Governor Poloz’s view was echoed in the BoC’s latest Monetary Policy Report (MPR), which was also released last week. The BoC said that “recent higher inflation is attributable to the temporary effects of higher energy prices, exchange rate pass-through and other sector-specific shocks, rather than to any change in domestic economic fundamentals.” The BoC acknowledged that inflation may “fluctuate” around its 2.00% target over the next two years, but it believes that the upward pressure that has come from today’s transitory effects will be roughly offset “by the downward pressure on inflation from economic slack and heightened retail competition”.

Bluntly put, our recent inflation surge doesn’t seem to be keeping our central bankers in Ottawa up at night. If they’re having trouble sleeping, it is far more likely that their insomnia is caused by their “serial disappointment” in global economic momentum as it proceeds on a “lower growth track”, and by reduced expectations for Canada’s economic growth, which the Bank now expects will be “a little weaker than previously forecast”.

In the latest report, the BoC also moved out its estimate of when our economy will return to full capacity, to mid-2016. The Bank seems cautious about this timing, however, saying that the mid-2016 projection for closing the output gap “is reliant on continued stimulative monetary policy and hinges critically on stronger exports and business investment”, both of which have yet to materialize in any meaningful way.

(As a reminder, the “output gap” describes the difference between our actual output and our maximum potential output, and “full capacity” means that there is no unused slack left in our economy. These are important terms for mortgage borrowers because interest rates are expected to rise when the output gap closes and our economy returns to full capacity.)

That said, these cautious reassurances from the BoC about our benign inflation rates and the slower than expected growth of our economy were not designed to reassure Canadian mortgagors. Rather, they were the continuation of BoC Governor Poloz’s plan to talk the Loonie down, and in so doing, to give a boost to our beleaguered export manufacturers.

Truth be told, Governor Poloz would probably rather keep Canadians worried about higher rates in order to keep the risks associated with “household [debt] imbalances … evolving in a constructive way”. It’s just that at the moment, he’s got more pressing matters keeping him awake at night.

Five-year GoC bond yields fell by four basis points last week, closing at 1.49% on Friday. Five-year fixed-rate mortgages are available in the 2.79% to 2.94% range and five-year fixed-rate pre-approvals are offered at rates as low as 2.99%.

Five-year variable-rate mortgages are available in the prime minus 0.75% to prime minus 0.60% range, depending on the terms and conditions that are important to you.

The Bottom Line: On first glance, the CPI’s return to the BoC’s 2.00% target would be expected to push our mortgage rates higher. But the transitory and limited nature of our recent price rises has not spooked investors, and the BoC’s downgraded growth forecasts along with the soothing inflation commentary in its latest MPR have also helped to assuage their fears.